In Part One we explored why you should never ask a barber if you need a haircut and why you should never rely on instructions from Proctor & Gamble for how much of their washing liquid you should be using.
Today in Part Two we are going to look a bit closer at conflicts of interest in financial advice.
The Escape Artist has said some rude things in the past about wealth managers and financial salespeople. And let’s be honest, there are some absolutely awful business models and (lack of) ethics out there in the product-focussed world of the financial salesman.
But, given that I do financial coaching, I guess I have a horse in this race (even though I don’t sell or recommend financial products or otherwise give regulated financial advice). So perhaps we should listen to a financial adviser who talks honestly about the good and the bad of their own industry. Here I want to introduce Carl Richards of The Behavior Gap. Today’s post contains a short extract from his excellent book.
What is The Behavior Gap? It’s is the gap between the behaviour that we know we should do and what we actually do in practice. It’s the bad investor behavior (buying high, selling low, churning, market timing, poor fund/stock selection etc) that leads to investment returns that are less than the return you’d get from just buying and holding a tracker fund.
Often the problem is not lack of information, its behavioural. Most investors realise they shouldn’t try to time the market…but then do so anyway. We all know that you need to earn more, spend less and invest the difference to build wealth but people still struggle to do this in practice.
The human factor requires a multi-disciplinary approach. In psychology, behaviorism is an approach that focuses on what people actually do and why they do it. Behaviorism helps explain the concepts of conditioning and programming that form the basis of Your Money Blueprint.
And in economics there is a concept called “revealed preferences”. In other words, what does people’s actual behaviour (including their spending) reveal about what they value? If someone spends £100 per month on doughnuts and nothing on bikes / gyms / trainers…well, they may say they value health but do they really?
You should pay as much attention to what people do as to what they say. Talk is cheap and people often say things in public that are contradicted by what they think / say / do in private (this is particularly relevant as The Culture War plays out and The Overton Window has shrunk).
If words are not consistent with actions, I suggest you go with what the actual behaviour tells you. As someone smart once said, show me a person’s bank statement and their calender schedule, and I will tell you what their priorities really are.
Dealing with other people is much easier if you work with human nature rather than try to deny it. When you think about other people’s incentives, their behaviour becomes much easier to understand.
So if you are thinking about hiring a financial advisor, you need to understand clearly how their fee structure (and their incentives) operate. If you don’t know how much you paid them last year (and can’t figure it out), then you don’t understand it.
That’s enough from me, here’s Carl…enjoy.
The myth of unbiased advice
It would be nice to think that your financial advisor’s interests are always entirely aligned with your interests. But that’s just not true.
Outright crooks like Bernie Madoff are the exception. Most financial advisers are trying to make a living by helping their clients.
Sometimes, however, those two goals are in conflict. That’s okay – but only if we understand that the conflict exists.
People often ask me to create a checklist that will help people choose a financial advisor. The kind of checklist they have in mind usually starts off by asking how the advisor is compensated.
The idea is that if you know this, you’ll know whether the advisor is likely to recommend unsuitable investments that will line his or her pockets (with commissions, for example).
Here’s my take: conflicts of interest are inherent in almost any situation when you’re paying for advice. Lawyers, accountants, financial advisors, auto mechanics…we all have to cope with situations when our interests may not fully align with the interests of our clients, at least in the short run.
Your job is to identify those conflicts of interest, and then keep them in mind as you make your decisions. Think of it this way: when you walk into a Toyota dealership, you don’t expect the guys there to tell you that Hondas are the greatest car around. You hope they’re honest, but you know they’re going to try to sell you a Toyota – and you make your decisions accordingly.
When you’re working with a financial advisor, it does help to know how he or she is compensated. There are three basic models:
- You can pay by the hour for advice
- You can pay a fee based on some percentage of your assets; or
- You can hire a person who earns commissions selling you products
Many advisors mix two or three of those models. Others limit themselves to a fee-only model, others rely heavily on commissions.
There is a great deal of debate about which model is best. The answer depends on your situation – what kind of advice you need, your budget, and so on. And while the commissions-based model offers the most potential for conflicts of interest, no model can eliminate them. A fee-based planner may lose money when a client withdraws savings to paydown his mortgage but it might be the right thing for the client. That’s a potential conflict of interest right there.
What really sets good advisors apart is honesty. Are they open about conflicts, and do they manage those conflicts with integrity?
True, judging an advisors integrity is not always easy. It takes time to develop trust – and in the early stages, you may have to work hard and spend a lot of time making sure you really understand the advice you’re getting.
Over time you can streamline the process, but it should always be a partnership. Along the way, keep these points in mind.
Firstly Wall Street is in the business of selling stuff. That is it’s purpose on earth. It has a duty to shareholders to maximise profit, not necessarily share it with its customers. There are exceptions, but its unwise to pretend that the people on the other side of the desk have a duty to put your interests in front of those of the firm that employs them.
Second, financial advisors are required to disclose to you the information you need to make educated decisions. Your job is to read and ask questions until you know what you’re talking about and feel ready to make decisions. “Whatever you say” is not a good answer to the question: “What do you think we should do with your portfolio?”. A better answer: “I don’t know; tell me what you think, and then I’ll ask you about sixty-five questions”.
Third, much of the advertising from the industry makes you think you are getting independent advice – but for the most part, you are not.
Financial advice comes from people whose interests are often in direct conflict with ours. And that’s fine, as long as we recognize it. There is nothing illegal about trying to sell someone something.
Fourth, no one is forcing you to buy anything. Keep asking questions until you know what you’re doing. Then, and only then, take action.
I send out occasional emails with my thoughts and what I’m up to. You can sign up for those emails below 👇